Revenue Ruling 99-5 and Section 1031: Bob and Jon’s Excellent Adventure—Part I

Jon was the sole member of Apartment LLC, a disregarded entity for tax purposes. Apartment LLC owned a small apartment building as its only asset. Things were going well with that apartment building.

Bob had some extra cash from golf winnings and was looking for a real estate investment. He saw how well Jon’s apartment building was doing, and asked if he could buy into Apartment LLC. Jon liked the idea and offered to sell Bob a 40% membership interest. Jon knew there would be quite a bit of gain associated with that sale, since the apartment building had appreciated a lot over the years. He wondered if he could use Section 1031 and do a like-kind exchange to avoid recognizing that gain.

Section 1031(a) provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment (relinquished property) if the real property is exchanged solely for real property of like kind (replacement property) that is to be held either for productive use in a trade or business or for investment.

When Jon read this, he was crestfallen. He wasn’t selling real property to Bob; he was selling a membership interest in an LLC that owned real property. And Jon knew that Section 1031 required very exacting compliance with its rules. However, Jon’s friend Matt suggested that he have a look at Revenue Ruling 99-5.

Situation 1 of Rev. Rul. 99-5 involves A being the sole member of a disregarded LLC, and B wanting to buy a 50% membership interest from A—very similar to Jon and Bob’s situation. The sale of the membership interest would create a multi-member LLC, taxed as a partnership by default. The tax treatment, according to Rev. Rul. 99-5, would be:  “B’s purchase of 50% of A’s ownership interest in the LLC is treated as the purchase of a 50% interest in each of the LLC’s assets, which are treated as held directly by A for federal tax purposes. Immediately thereafter, A and B are treated as contributing their respective interests in those assets to a partnership in exchange for ownership interests in the partnership.”

This made Jon very happy. Under Rev. Rul. 99-5, he would be treated for tax purposes as owning the apartment building itself, selling a 40% interest in the apartment building to Bob, with he and Bob then immediately contributing their interests in the apartment building to Apartment LLC in exchange for their membership interests in Apartment LLC. Since Jon would be treated for tax purposes as selling an interest in real property, the 40% membership interest in Apartment LLC qualified as viable relinquished property under Section 1031.

When Jon explained all this to Bob, Bob wondered if he might also benefit from Rev. Rul. 99-5. Bob had a rental house on the market. Rather than use his cash from golf winnings to buy the 40% membership interest from Jon, could he apply the proceeds from the sale of the rental house toward the purchase, in a 1031 exchange? After all, the rental house was real property and clearly qualified as relinquished property under Section 1031. Rev. Rul. 99-5 said that he was being treated as buying an interest in the apartment building, which would be his replacement property, and then immediately contributing it to Apartment LLC for the membership interest.

Bob would have a harder time with his position. The problem is that Bob is treated as holding the real property for a nanosecond, and then transferring it to Apartment LLC for a membership interest. It doesn’t seem like the interest in the apartment building is being “held for investment,” and it seems very easy to collapse the two steps with a “step transaction” argument. There is no authority directly on point. There are cases Bob could rely on to make his argument, like Bolker[1], and especially, Magneson[2]. But it would be a risky position. My guess is that Bob would be challenged by more aggressive taxing authorities like the California Franchise Tax Board, and the outcome would probably depend on which judges were on the Office of Tax Appeals panel deciding the case.

[1] Bolker v. Commissioner, 760 F.2d 1039 (9^th Cir. 1985)

[2] Magneson v. Commissioner, 753 F. 2d 1490 (9th Cir., 1985)